XLK: The One Chart You Need to Watch in August

Investors who want to gauge how far the U.S. stock market can run — or fall — from here need only focus on a single ETF in the month ahead: the Technology SPDR (XLK[1]).

Here’s why: Among all the major sectors, and indeed the market itself, technology is closest to its lower trendline. The chart below, from midday Thursday, shows XLK trading at $31.54 — 3.8% above the current termination point for its trendline at $30.35.

Keep in mind, this number isn’t static — the rising slope of the line means that its endpoint moves slightly higher each day.

This matters for the simple reason that the broader market itself is in a similar technical position, but it has further to go to break down.

Early Thursday afternoon, the S&P 500 Index was trading at 1,682, which put it 5.2% from its lower trendline at 1,595. The S&P MidCap and Russell 2000 indices were even further away from their trendlines, with about 7% of downside to act as a cushion before they reach dangerous technical territory.

XLK, by being closer to its trendline than the major indices, therefore has the potential to act as an early-warning system for the rest of the market. As long as it can hold its trendline, stocks should stay in fairly good shape barring a surprising adverse headline.

On the other hand, a breakdown for XLK means that it’s time to go on alert for similar weakness in other sectors — and ultimately the market itself.

The Lessons of 2011

It might seem too early to raise the warning flag given the recent strength in stock prices, but investors might recall that a similar pattern emerged during the summer of 2011.

Amid what appeared to be an otherwise healthy market, the Financial SPDR (XLF[2]) broke below its 200-day moving average in early July even as the broader indices remained about 5% above their respective 200-day MAs. The Industrial SPDR (XLI[3]) subsequently broke its 200 on July 27, providing yet another signal to attentive investors. The broader market held in for three more days following XLI’s breakdown, then proceeded to shed 15% to its ultimate intra-day trough a week later.

That selloff was a surprising development in what had been a relative quiet year up until that point, but investors who used the signals provided by XLF and XLI had ample time to protect themselves from the decline.

Homebuilders, Refiners Have Already Broken Down

XLK, if it breaks, will be the first major sector to show technical weakness. However, certain key subsectors have also suffered such a fate in recent weeks. Notably, these include three former leadership groups: homebuilders, REITs and refiners. The iShares U.S. Real Estate ETF (IYR[4]) broke down in May, while iShares U.S. Home Construction ETF (ITB[5]) fell below its lower trendline in late June, and refining stocks such as Tesoro (TSO[6]) began printing weak charts earlier this month.

Alone, these developments might not mean much, and they can be written off to specific news events (higher rates, slower housing data and a narrowing of the spread between Brent Crude and West Texas Intermediate price[7]s, respectively). But together, they form a pattern — and one that makes keeping an eye on XLK all the more important.

Bottom Line

XLK might well hold its ground here, especially as it can be supported simply by strong performance from Apple (AAPL[8]) and Google (GOOG[9]), which together make up over 20% of the portfolio. Still, the events of July-August 2011 indicate that investors would be well-served by monitoring the tech sector closely in the weeks ahead.

As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.